The Story Of Taxes & Inflation

Together, taxes and inflation create a web of incredible treachery, serving as another example of how The Rules of Money Have Changed.

At the turn of the twentieth century, taxes and inflation were not a concern. Homes cost $5,000 (Sears used to sell them from their catalog), and if you wanted to borrow money to buy your house, the bank charged you from 4% to 6%. If you deposited money into the bank, the bank paid you 2%; its profit was the difference between what it charged and what it paid.

Why were our parents and grandparents willing to accept a 2% return on their savings? Because it was profitable for them to do so: With no inflation, the 2% they earned was a real 2% and, with no taxes to pay, they got to keep it all. Thus, our parents and grandparents were able to prosper from a 2% return on their money and banks were able to prosper by charging only 4% or 6% for their loans.

Banks were willing to offer 30-year mortgages at these low rates because it had always been profitable to do so. Indeed, from 1879 to 1965, mortgage rates in the U.S. were very stable, consistently at 5.3%, give or take half a point. But something happened in 1966. Rates began to rise and they’ve been fluctuating ever since.

Amazing! Interest rates that had remained constant since the end of the Civil War suddenly began to fluctuate, rocketing from 5.7% to 16.5% and crashing back down again.

Why did this happen? Well, I’ll tell you:

I don’t know.

But I can tell you what happened to banks as a result: They were decimated. In 1965, they gave borrowers 30-year, fixed-rate loans at 5.8%, but by 1980 they were paying 21% in CD rates. So, the banks found themselves earning 5.8% but paying out 21%. Yup, that’s a good way to decimate a bank, and that’s why, in the 1980s, more banks failed than in any period since the Depression.

Bankers — some of the smartest economic minds in the nation — didn’t see inflation coming, so it’s no surprise that ordinary consumers didn’t, either.

My point is that our parents and grandparents were able to succeed financially with a 2% bank account, yet if we do what they did — if we handle our money the way they handled theirs — we will fail where they succeeded.

Here’s why: Assume CD rates are 3%. If you are in the 33% combined federal/state income tax bracket, you lose to taxes a third of everything you earn. Thus, if you earn 3%, you lose 1%, and keep only 2%.

But if inflation maintains its average since 1985, you’d actually lose money. This is why many people fail financially. They focus on how much they earn instead of how much they keep. What counts is your after-tax, after-inflation rate of return. You’ve got to earn more than the current combined rate of inflation and taxes in order for your money to grow in real terms. To determine the minimum rate of return that you need to earn to beat taxes and inflation, look at the figure below.

The irony is that everybody is lamenting today’s low interest rates, compared to those of the past thirty years, and my firm gets lots of calls from people complaining that interest rates have dropped. “Banks are not paying good rates anymore,” they say.

My colleagues and I at Edelman Financial find this quite funny, because banks never paid “good rates.” It’s just that you’re noticing for the first time! You see, CD rates — like all interest rates — simply track inflation. When inflation rates are high, interest rates are high, and when inflation drops, interest rates drop. In 1980, for example, when interest rates were 15%, inflation was 13%.

Do the math: If you earned 15% on a CD, you netted 10% after taxes. But with 13% inflation, you were still losing in real terms. In other words, you were just as broke earning 15% in 1980 as you are earning 2% today. You simply never noticed.

Now that you are thoroughly demoralized, let me assure you that there is a way out of this tax-and-inflation trap. And that leads us to the.